A Great Way to Lose a Lot of Your Hard-Earned Money

This year's horse-racing Triple Crown hopeful, I'll Have Another, has been scratched from the Belmont Stakes race. For a great many Belmont Stakes betters, this is great news, because they were about to make a terrible mistake.

Last week, Motley Fool Money fans were treated to a great interview with horse-racing expert Steven Crist. For those who didn't catch the interview (though I highly suggest that you go back and listen to the whole thing), here is what Crist had to say about the then-favorite of Belmont:

The last 11 horses who've won the Derby and Preakness and came to the Belmont with the chance of winning the Triple Crown all lost at the Belmont. Despite that, I'll Have Another is going to be roughly even money to win the Belmont. So if you're betting on I'll Have Another, you're taking 50-50 odds on something that has failed 11 times in a row. It's a terrible, terrible bet. Even if he wins this race that'll be only one out of the last 12 and you'll only have doubled your money.

Investors, do yourself a favor and don't brush that off, thinking, "That's just horse racing." What Crist is talking about is the exact same thing investors do all the time.

I'll Have Another is a fine horse, but winning the Triple Crown is a long shot. With only one of the last 12 horses able to pull it off, we could say that there would have been something like an 8% chance that I'll Have Another would have pulled it off. Meanwhile, the way betters were wagering, it implied that there was more like a 50% chance that it would happen.

And as Crist went on to note, this is the same kind of pattern that emerges every time a horse has a shot at the Triple Crown. As you can easily deduce from the numbers, betting on an 8% proposition that's priced like a 50% proposition is a great way to go broke betting on horses.

But is this really any different from the way investors went after, say, Facebook (Nasdaq: FB) ? Facebook is an impressive company that built a significant business and an impressive profit run-rate in its relatively short lifespan. But growing consistently at rates of 40%, 50%, or more is something very few companies are able to pull off. Yet when Facebook went public, the price-to-earnings ratio of about 100 that investors applied to the stock implied that there is a very high -- almost guaranteed -- likelihood that Facebook will indeed grow that fast for a long period of time.

Crist went on: "There are horses that are great bets at 3-to-1, and the same horse is a terrible bet at even money. I think similarly with buying stocks: There are wonderful companies whose stock is overpriced at any given moment, and it would be a bad investment even if it's a good company."

There are converse examples that fly in the face of this notion of avoiding supposedly overvalued stocks. Amazon.com (Nasdaq: AMZN) has never looked cheap, yet its astounding growth has helped make investors a lot of money despite the high price. In its early years as a publicly traded company, Google (Nasdaq: GOOG) fetched an astoundingly high valuation, but its growth proved out and rewarded investors well.

Will Facebook follow suit and deliver killer growth that will justify its high IPO-day price tag? It's certainly possible. But the broader point here is that investors who consistently make that long-shot bet and don't get compensated with long-shot odds -- in investing terms, that would be a low valuation -- will likely end up net losers.

Crist again: "[I realized] it really was a game that was as much about value as it was about picking winners. … What you look for is for the public to make mistakes in valuation and take advantage of those mistakes."

While everyone is busy talking about Facebook and other highfliers, companies like ConocoPhillips (NYSE: COP) and Hewlett-Packard (NYSE: HPQ) are trading at well-below-market valuations. There's money to be made by investors, thanks to other investors' mistakes. However, most of that money will be made outside of hot-shot stocks like Facebook.

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Comments from our Foolish Readers

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The horse racing analogy is a poor one. Each horse that wins the Kentucky Derby and the Preakness is a separate individual with its own chance of winning the Belmont, much as a toss of a coin or a roll of the dice is separate and unique. What has happened before has no bearing on THIS trial. What happened with Big Brown in 2008 has nothing to do with I'll Have Another this year. This is known as The Law of Independent Trials.

That said, I see no reason to buy Facebook at its current price, because I don't see how it's going to make enough money to support a reasonable P/E. I may take a swing at it if it declines to $20.

"What happened with Big Brown in 2008 has nothing to do with I'll Have Another this year."

While true, the stat about pulling off the Triple Crown speaks to the difficulty of a horse winning all three of those highly competitive races. No, the performance of the previous horses don't directly impact (or wouldn't have directly impacted) I'll Have Another, but it shows that betting on the final leg of the Triple Crown is a long-odds proposition.

And the same goes with stocks. The fact that many high-flying companies in the past have failed to live up to inflated growth expectations doesn't directly impact Facebook (for example), but those missed expectations show how difficult it is to deliver on outsized growth for an extended period.